What is its current value of operations (i.e., at time zero)?
Critical analysis of firm valuation models (60%)
Empirical finance research has a considerable amount of studies on firm valuation models in
recent years (see for example, Imam et al., 2013; Penman and Sougiannis, 1998; Francis et
al., 2000; Courteau et al., 2001, Demirakos et al., 2004 and Bradshaw, 2002, 2004, and 2009).
Extant research mostly focus on the use of valuation models by the US investment analysts
while there is a specific paper that investigated the use of valuation models by UK based
investment analysts (Imam et al., 2008). Therefore, it would be interesting to see the variation
of preference by the US and UK analysts. On a different note, theory suggests that all models
should give identical valuations if they are properly constructed. Penman and Sougiannis
(1998) provide evidence that the residual income (RI) model yields more accurate firm
estimates than the dividend discount model (DDM) and the discounted cash flow (DCF) model.
Required:
Based on the relevant literature, critically discuss:
1. All three models of valuation and establish their comparative performance reflecting on their
strengths and weaknesses in order to produce the best valuation estimates for stocks and firms.
2. The differential preference by the US and UK investment analysts, if any and their
justifications.
Part B: Stock valuation (40%)
HRM Plc, a mid-sized human resources management company, is considering expansion
into related fields, including the acquisition of Lake View Company, an employment
agency that supplies word processor operators and computer programmers to businesses
with temporary heavy workloads. HRM is also considering the purchase of Biggerstaff &
McDonald (B&M), a privately held company owned by two friends, each with 5 million
shares of stock. B&M currently has free cash flow of £24 million, which is expected to
grow at a constant rate of 6%. B&M’s financial statements report short-term investments of
£100 million, debt of £200 million, and preferred stock of £50 million. B&M’s weighted
average cost of capital (WACC) is 11%.
Required:
1. Use B&M’s data and the free cash flow valuation model to answer the following
questions:
i. What is its estimated value of operations?
ii. What is its estimated total corporate value? (This is the entity value)
iii. What is its estimated intrinsic value of equity?
iv. What is its estimated intrinsic stock price per share?
2. You have just learned that B&M has undertaken a major expansion that will change
its expected free cash flows to −£10 million in 1 year, £20 million in 2 years, and
£35 million in 3 years. After 3 years, free cash flow will grow at a rate of 5%. No new debt or preferred stock were added, the investment was financed by equity
from the owners. Assume the WACC is unchanged at 11% and that there are still
10 million shares of stock outstanding.
i. What is its horizon value (i.e., its value of operations at year three)?
ii. What is its current value of operations (i.e., at time zero)?
iii. What is its value of equity on a price per share basis?
Guidance:
1. You should allocate about 1200 words for Part A. For Req 1, you may take about 900
words and for Req 2, you can use about 300 words.
2. Remaining 300 words can be dedicated to Part B.
3. For Part A, you should explore the relevant literature that critically discussed and
evaluated the competing valuation models and based on the literature you may report
their comparative strengths and weaknesses as a valuation model.
4. You are encouraged to explore additional research peer-reviewed research papers
relevant to your response for Part A.
5. For Part B, you should consult relevant textbooks for supporting concepts and formulas.
